Scary Results At Long-Short Equity Funds

If the market's Brexit tantrum has reminded you of the pain of volatility, you may be hunting for something magical on Wall Street: an investment that delivers most of the return from stocks but much less of the risk.

Hedge funds, those private partnerships offered to a select crowd, try to accomplish this by mixing stock purchases with short sales. The theory is that in a rising market the carefully selected long positions race ahead; in a correction, profits on the short sales insulate the portfolio from the worst of the decline.

Now ordinary folk can get in on the action. An expanding collection of publicly traded mutual funds combine long and short positions in stocks. With these, you can get hedge-fund-like returns.

Important question: Do you really want hedge-fund-like returns? Take a look at them before signing up.

Morningstar counts 133 publicly offered funds in its "long-short equity" category, holding a combined $34 billion. Results: awful. The average return for the bunch has been 2% a year over the 36 months to June 30. You could have had 11.7% a year from a stock index fund.

Hedge-fund-like? Sure, if that's any consolation. An index of equity hedge funds tracked by Hedge Fund Research shows a 3.1% annual return over three years, almost as bad as the return from the public long-short funds.

The question is why an ordinary saver would really need this stuff. For an answer we turned to Goldman Sachs, which oversees $112 billion of alternative assets (those being almost anything other than plain old stocks and bonds) and has 40 years of experience in the field.

Lawrence Restieri Jr., who helps market alternative investments at Goldman, says the idea is to get exposure to asset classes that are not closely correlated with the stock market. "Adding a return driver that behaves differently can help clients over time," he says. "You don't want the client, after an equity market crash, to sell all their equities and not get back in [before] the market recovers."

Protecting investors from self-inflicted wounds is a worthy goal. But are long-short mutual funds a good way to achieve it?

Consider what the funds do to reduce risk. They have, on average, a sensitivity to stock market fluctuations that is equivalent to a 50% long exposure. (That could come, for example, from investing the whole wad in long positions, then taking on short sales equal to half that amount.) But there are easier ways to go 50% long. You could just put half your money in cash.

Someone who spent the last three years half in cash and half in a stock index fund--SPDR S&P 500 (SPY) or Vanguard 500 ETF (VOO)--would have landed an annual return just shy of 6%. That's four points better than what the long-short mutual funds delivered. In short, the long-short customers have allowed a lot of money to slip between their fingers.

Josh Charlson, who analyzes alternative investments for Morningstar, has some theories about what went wrong. The long-short crowd may have made too many short-sale bets against highfliers like
Netflix and Amazon. Then there are frictional costs to their trading. Turnover in the category averages an effervescent 260% a year.

The biggest single drag on the results is the fees. Those 133 strivers have taken on a very challenging assignment--answered with "proprietary" models, "high conviction investments" and "patent pending" strategies--and charge accordingly. The average expense ratio runs to 1.9% a year. That's 38 times as high as for a stock index fund.

The Goldman Sachs Long Short Fund has 2.4% in annual expenses and a 468% turnover. Not quite two years old, it has delivered an average annual return of -9%.

Could you improve the odds of success by choosing only the best-performing funds? Don't count on it. Performance-chasing investors have an unfortunate habit of getting in at the top and bailing out at the bottom, says John Bogle, who founded Vanguard Group 41 years ago on the theory that investors should seek economy and simplicity in their portfolios. As a result, he says, the return on an average investor's dollar is often less than the return you see in a performance chart.

A case in point is the Gotham Absolute Return Fund, opened to much enthusiasm in 2012. Gotham founder Joel Greenblatt made a name for himself with his The Little Book That Beats the Market (John Wiley & Sons, 2010). The fund drew in billions of dollars to follow Greenblatt's "magic formula investing," which has the fund buying 530 scientifically selected stocks and shorting smaller doses of 448 others.

If you had bought this fund three years ago and stayed put, you would have gained 4.6% a year. That's not great for a fund with a 60% market exposure, although it does leave Gotham ahead of its dismal peer group.

Gotham's restless customers, alas, did not stay put. They had more money on the table during the bad months than during the good ones. Their average result, Morningstar reports under its "investor return" tab, has been -2.8% a year.

You could try to make your move into hedge-fund-like investing at just the right time, just before the magic formulas start working. But the odds are against you.

"You pay a terrible price for thinking you're smarter than the market," Bogle says. If you're worried about volatility, see if you can come up with a reduced-risk portfolio that has low turnover and low expenses. He recommends a 50-50 blend of an S&P 500 index fund and a short-term bond fund.